When one considers recent news coverage, government-backed bailouts seem to be the option of choice for financially distressed firms across industries. But the authors of this paper argue that Chapter 11 of the U.S. Bankruptcy Code, which allows distressed companies to reorganize and make new arrangements with lenders rather than liquidate the company, does an effective job of determining which companies should continue operating and which should not. After studying the bankruptcy filings of more than 500 firms that filed for Chapter 11 protection between 1991 and 2004, the authors found that 80 percent of companies with fundamentally sound business models that had run into financial problems emerged from Chapter 11 proceedings with only 7 percent fewer assets. Habitually unprofitable firms, such as those with flawed business models or outdated technology, fared far worse: Just 37 percent of these firms emerged from bankruptcy, typically with less than 50 percent of their original assets. The firms that did not make it out of bankruptcy were liquidated to pay back lenders. The authors conclude that Chapter 11 proceedings are successful in shutting down those firms that are destroying the value of their assets and in helping prevent distressed, but otherwise sound, companies from going under.

Bottom Line:Not all firms deserve financial bailouts, and Chapter 11 proceedings are effective at determining which companies should remain in business.

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